Many readers of this column take me up on my offer for free financial advice. 'Mr. K' from Michigan, like many, wondered about taxes owed on his mother's house. Chances are you will deal with the same issues.

He writes, "I have a question about my mom's home that I inherited. Before my mom died she put her real estate into joint ownership between her and my sister. It was supposed to help make settling her estate easier. Before mom passed away, my sister died. After my sister died, mom placed the real estate jointly between herself and me. Mom passed away over a year ago and I am now contemplating the sale of her house. After mom's death I had the home transferred to my and my wife's names.

What are my capital gains liabilities on the sale of the house? Do I pay capital gains on the whole sale, half the sale, or none of the sale?"

Mr. K's question provides an excellent opportunity to clarify the confusing matter of gifting and inheritance. Few people are aware of the tax implications and needlessly end up creating a tax headache for themselves and their loved ones.

Let's explain what an inheritance is and how it differs from a gift. An inheritance is money, property, or another asset of value that is transferred after death. A gift occurs when money, property or other assets are transferred before death. An inheritance and a gift are handled very differently from a tax standpoint.

Each of us can give gifts up to $12,000 per year to any person we want without any Federal tax implications. (There may be some state gift tax implications so check with an accountant.)

Inheritances aren't subject to Federal Estate Tax unless the estate's value is over a certain amount, which as of January 1st, 2006 is two million dollars. Because all assets owned by the deceased are included in the estate's valuation (i.e. retirement accounts, annuities, life insurance, etc.), reaching that two million dollar limit is easier than you think.

Even if there is no gift or estate tax when the assets are transferred, there can be capital gain taxes when the assets are sold. The trick is determining the asset's original value, or cost basis, and that depends on whether the asset was a gift or an inheritance.

When you receive a gift, you also receive the cost basis the person giving the gift had. So, if a parent paid $10,000 for a home and it was worth $100,000 when it was gifted to the child, the child now has a cost basis of $10,000. If the house is sold 5 years later for $125,000, the child will owe taxes on a gain of $115,000.

If the house was instead inherited by the child, the cost basis is the value of the house at the time of inheritance, which in our example would be $100,000.

So when the house is sold 5 years later for $125,000, the child only owes taxes on the gain of $25,000. In tax parlance, the house received a step-up in basis when transferred after death. It doesn't if transferred prior to death.

Let's apply this to Mr. K's situation. When Mom added Sister's name to the deed, it was a gift to the sister of 50% of the value of the home and sister's cost basis was 50% of Mom's cost basis.

When sister died and the house transferred back to Mom, it was considered an inheritance. So Mom's cost basis on the 50% she inherited was the market value at the time she inherited it back. So 50% of Mom's ownership is based on her original cost basis and the cost basis of the other 50% is the value at Sister's death.

When Mom then adds Mr. K's name to the property, it's another gift. So Mr.K will inherit 50% of Mom's new, adjusted cost basis. When Mom dies and the other 50% is transferred to Mr. K, his cost basis in that 50% is the value at the time of Mom's death.

Now you know why accountants make all that money!